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CFA Level III FOR AIMR USE ONLY

Examination Book

1999 Morning Section


Candidate Number:

_____ _____ _____ _____ _____ _____

1999 Association for Investment Management and Research


All rights reserved

This book is the property of:

Association for Investment Management and Research


Post Office Box 3668
Charlottesville VA 22903-0668 (804) 980-3668
The following list contains the command words used on the Morning Section of
the 1999 Level III Examination. Candidates may want to refer to this list as they
formulate their answers.

calculate: To ascertain or determine by mathematical processes.

compare: To examine the character or qualities of for the purpose of discovering,


primarily, resemblances.

construct: To create by organizing ideas or concepts logically and coherently.

critique: To offer a critical review or commentary; to criticize.

describe: To transmit a mental image, an impression, or an understanding of the nature


and characteristics of.

determine: To come to a decision as the result of investigation or reasoning; to settle or


decide by choice among alternatives or possibilities.

discuss: To discourse about through reasoning or argument; to present in detail.

evaluate: To determine or fix the value of; to determine the significance or worth of,
usually by careful appraisal and study.

formulate: To put into a systematized statement or expression; to prepare according to a


formula.

identify: To establish the identity of; to show or prove the sameness of.

justify: To prove or show to be valid, sound, or conforming to fact or reason; to


furnish grounds or evidence for.

list: To enumerate.

select: To choose from a number or groupusually, by fitness, excellence, or other


distinguishing feature.

show: To set forth in a statement, account, or description; to make evident or clear.

state: To express in words.


The Morning Section of the 1999 CFA Level III Examination has 11 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question Topic Minutes


1 Portfolio Management 24
2 Portfolio Management 6
3 Portfolio Management 12
4 Portfolio Management 16
5 Portfolio Management 24
6 Portfolio Management 33
7 Portfolio Management 15
8 Economics 12
9 Global Markets and Instruments 18
10 Ethics 6
11 Ethics 14

Total 180
Questions 1 through 5 relate to Peter and Andrea Mueller, individual investors. A total
of 82 minutes is allocated to these questions. Use the first few minutes to review the
Introduction below. Candidates should answer these questions in the order presented.

INTRODUCTION

Peter and Andrea Mueller, U.S. residents, are reviewing their financial plan. The Muellers, both
age 53, have one daughter, age 18. With their combined after-tax salaries totaling $100,000 a
year, they are able to meet their living expenses and save $25,000 after taxes annually. They
expect little change in either their incomes or expenses on an inflation-adjusted basis other than
the addition of their daughters college expenses. Their only long-term financial goal is to
provide for themselves and for their daughters education. The Muellers both wish to retire in
ten years.

Their daughter, a talented musician, is now entering an exclusive five-year college program.
This program requires a $50,000 contribution, payable now, to the colleges endowment fund.
Thereafter, her tuition and living expenses, to be paid entirely by the Muellers, are estimated at
$40,000 annually.

The Muellers personal investments total $600,000, and they plan to continue to manage the
portfolio themselves. They prefer conservative growth investments with minimal volatility.
One-third of their portfolio is in the stock of Andreas employer, a publicly traded technology
firm with a highly uncertain future. The shares have a very low-cost basis for tax purposes. The
Muellers, currently taxed at 30 percent on income and 20 percent on net realized capital gains,
have accumulated losses from past unsuccessful investments that can be used to fully offset
$100,000 of future realized gains.

In ten years, Peter will receive a distribution from a family trust. His portion is now $1.2 million
and is expected to grow prior to the distribution. Peter receives no income from the trust and has
no influence over, or responsibility for, its management. The Muellers know that these funds
will change their financial situation materially but have excluded the trust from their financial
planning.

QUESTION 1 HAS ONE PART FOR A TOTAL OF 24 MINUTES.

1. Construct the objectives and constraints portion of an investment policy statement for
the Muellers, addressing each of the following:

i. Return objective.
ii. Risk tolerance.
iii. Time horizon.
iv. Liquidity.
v. Taxes.
vi. Unique circumstances.

(24 minutes)
QUESTION 2 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

2. As part of their financial planning, the Muellers have been seeking advice from friends
and relatives. This advice includes the following comments:

An investment policy statement wont help you make any money.

The key to successful investing is simply to select investments that earn an


annual return higher than the stock markets return.

All hired investment managers will routinely change everything you have been

Discuss a potential benefit of using a written investment policy statement that contradicts
each of the above comments. (Note: Three different benefits are required.)

(6 minutes)
QUESTION 3 HAS ONE PART FOR A TOTAL OF 12 MINUTES.

Candidates should use information from the Introduction on page 4 and Exhibit 3-1 below to
answer Question 3.

The Muellers built up their $600,000 investment portfolio over many years through regular
purchases of mutual funds holding only U.S. securities. Each purchase was based on personal
research but without consideration of their other holdings. They would now like advice on their
total portfolio.

Exhibit 3-1
Mueller Investment Portfolio
Percent of
Type Market Sector Beta Total
Andreas company stock Stock Small-cap growth 1.40 35
Blue Chip Growth Fund Stock Large-cap growth 1.20 20
Super Beta Fund Stock Small-cap growth 1.60 10
Conservative Fund Stock Large-cap value 1.05 2
Index Fund Stock Large-cap index 1.00 3
No-Dividend Fund Stock Large-cap growth 1.25 25
Long-Term Zero-Coupon Fund Bond Government 5

3. Evaluate the Muellers portfolio in terms of the following criteria:

i. Preference for minimal volatility.


ii. Equity diversification.
iii. Asset allocation (including cash flow needs).

(12 minutes)
QUESTION 4 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES.

4. The Muellers are reviewing growth and income mutual funds in order to choose one for a
new investment. Their goal is to select a fund that will minimize volatility while
maximizing after-tax returns. They have narrowed the choice to the two funds in Exhibit
4-1.

Assume the Muellers are subject to a 30 percent tax rate on all income except net realized
capital gains, which are taxed at 20 percent. The Muellers no longer have any tax losses
available to offset realized capital gains.

Exhibit 4-1
Potential New Investments for the Muellers
Superior Growth Exceptional Growth
and Income Fund and Income Fund
10-Year Historical Averages
Total return 12.0% 9.0%
Return in up markets 23.0% 14.0%
Return in down markets 10.0% 1.0%
Beta 1.25 0.98
Forecasted Data
Expected dividend yield 1.0% 2.0%
Expected annual total return 11.0% 10.5%
Expected annual turnover 60.0% 10.0%

A. Select and justify which of the above funds is more consistent with the Muellers
goal by addressing both of the following criteria:

i. Return volatility. (No calculations required.)


ii. Expected one-year after-tax return. (Assume all turnover resulted in gains,
and show calculations.)

(12 minutes)

B. Discuss whether realizing losses can add value to a portfolio.

(4 minutes)
QUESTION 5 HAS TWO PARTS FOR A TOTAL OF 24 MINUTES.

Ten years have passed. The Muellers, now both age 63, will retire this year. The distribution
from Peters family trust will occur now. The Muellers current circumstances are summarized
in Exhibit 5-1 below.

Exhibit 5-1
The Muellers Revised Circumstances
Personal Circumstances and Assets Trust Distribution Assets
Pension income will total $100,000 a year The trust distribution totals $2,000,000
and will not increase with inflation. and occurs now. No tax liability is
Annual expenses will total $180,000 created by the distribution.
initially and will increase with inflation. The Muellers will maintain separate
Inflation is expected to be 2 percent a year. accounts for their personal assets and the
Their personal investments now total trust distribution.
$1,000,000 (excluding trust distribution). They do not plan to withdraw income or
The Muellers will rely on this $1,000,000 principal.
portfolio to support their lifestyle and do Tax liabilities produced by these assets
not wish to reduce their level of spending. will be paid from this portfolio.
The Muellers have health problems and They plan to donate these assets to an arts
neither is expected to live more than ten society when the surviving spouse dies.
years. All health care expenses will be They have made a minimum pledge of
covered by insurance. $2,600,000 towards construction of a new
The Muellers daughter is now financially building.
independent, and their sole investment The Muellers assume that at least one of
objective is to meet their spending needs. them will live at least five years and that
The Muellers are not concerned with neither will live more than ten years.
growing or maintaining principal. The An after-tax annual return of 5.4 percent
income deficit may be met with both is required over five years to meet the
investment income and by invading minimum pledge.
principal. The Muellers are concerned only that a
minimum gift of $2,600,000 is available.
5. A. Select and justify with three reasons the most appropriate of the four portfolios
from Exhibit 5-2 as an asset allocation strategy for the Muellers $1,000,000
personal assets.

(12 minutes)

B. Select and justify with three reasons the most appropriate of the four portfolios
from Exhibit 5-2 as an asset allocation strategy for the Muellers $2,000,000 trust
distribution assets.

(12 minutes)

Exhibit 5-2
Alternative Portfolios for the Muellers
(in percent)
Portfolios
A B C D
Asset Allocation
Domestic large-cap stocks 14 30 40 30
Domestic small-cap stocks 3 5 10 25
Foreign stocks 3 5 10 25
Intermediate-term fixed income 70 60 30 20
Cash equivalents 10 0 10 0
Total 100 100 100 100

Expected annual return


(nominal after-tax returns) 4.2 5.8 7.5 8.5
Annual standard deviation 6.0 8.0 13.0 18.0
QUESTION 6 HAS FIVE PARTS FOR A TOTAL OF 33 MINUTES.

6. June Klein, CFA, manages a $100 million (market value) U.S. government bond
portfolio for an institution. She anticipates a small, parallel shift in the yield curve and
wants to fully hedge the portfolio against any such change.

Exhibit 6-1
Portfolio and Treasury Bond Futures Contract Characteristics
Conversion Factor Portfolio Value/
Modified Basis Point for Cheapest to Futures Contract
Security Duration Value Deliver Bond Price

Portfolio 10 years $100,000 Not applicable $100,000,000


U.S. Treasury bond
futures contract 8 years $75.32 1 94-05

A. Discuss two reasons for using futures rather than selling bonds to hedge a bond
portfolio. No calculations required.

(6 minutes)

B. Formulate Kleins hedging strategy using the futures contracts in Exhibit 6-1 only.
Calculate the number of futures contracts to implement the strategy. Show all
calculations.

(6 minutes)

C. Determine how each of the following would change in value if interest rates increase
by 10 basis points as anticipated. Show all calculations.

i. The original portfolio.


ii. The Treasury bond futures position.
iii. The newly hedged portfolio.

(9 minutes)

D. State three reasons why Kleins hedging strategy might not fully protect the portfolio
against interest rate risk.

(6 minutes)

E. Describe a zero-duration hedging strategy using only the government bond portfolio
and options on U.S. Treasury bond futures contracts. No calculations required.

(6 minutes)
QUESTION 7 HAS TWO PARTS FOR A TOTAL OF 15 MINUTES.

7. George Johnson is considering a possible six-month $100 million LIBOR-based,


floating-rate bank loan to fund a project at terms shown in Exhibit 7-1. Johnson fears a
possible rise in the LIBOR rate by December and wants to use the December Eurodollar
futures contract to hedge this risk. The contract expires December 20, 1999, has a US$ 1
million contract size, and a discount yield of 7.3 percent.

Johnson will ignore the cash flow implications of marking to market, initial margin
requirements, and any timing mismatch between exchange-traded futures contract cash
flows and the interest payments due in March.

Exhibit 7-1
Loan Terms

September 20, 1999 December 20, 1999 March 20, 2000


Borrow $100 million at Pay interest for first three Pay back principal
September 20 LIBOR + 200 months plus interest
basis points (bps) Roll loan over at
September 20 LIBOR = 7% December 20 LIBOR +
200 bps

Loan First loan payment (9%) Second payment


initiated and futures contract expires and principal

9/20/99 12/20/99 3/20/00

A. Formulate Johnsons September 20 floating-to-fixed-rate strategy using the


Eurodollar futures contracts discussed in the text above. Show that this strategy
would result in a fixed-rate loan, assuming an increase in the LIBOR rate to 7.8
percent by December 20 which remains at 7.8 percent through March 20. Show
all calculations.

(9 minutes)
Johnson is considering a 12-month loan as an alternative. This approach will result in
two additional uncertain cash flows, as follows.

Loan First Second Third Fourth payment


initiated payment (9%) payment payment and principal

9/20/99 12/20/99 3/20/00 6/20/00 9/20/00

B. Describe the strip hedge that Johnson could use and explain how it hedges the
12-month loan (specify number of contracts). No calculations needed.

(6 minutes)
QUESTION 8 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.

8. A. Compare absolute purchasing power parity (PPP) and relative PPP.

(6 minutes)

B. Evaluate the usefulness of relative PPP in predicting short-term foreign exchange


rate movements. Justify by citing two reasons.

(6 minutes)
QUESTION 9 HAS TWO PARTS FOR A TOTAL OF 18 MINUTES.

After reviewing historical quantitative data with respect to investing in emerging markets and
venture capital, a consultant has recommended a substantial overweighting in both emerging
market equities and venture capital.

9. A. Discuss two potential benefits resulting from overweighting that are common to
both asset classes.

(6 minutes)

B. Discuss four potential problems resulting from overweighting that are common to
both asset classes.

(12 minutes)
QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

10. Anthony Dexter is President and CEO of Welsh Investment Managers. Dexter is very
interested in promoting ethical conduct among his companys employees and begins by
adopting a code of ethics.

List six additional specific actions that Dexters firm can take to implement an effective
compliance policy.

(6 minutes)
QUESTION 11 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.

11. FIA Advisors (FIA) is a medium-sized investment advisory firm that employs 15
portfolio managers. FIA has full discretionary authority in managing the pension plan
assets for all of its clients. As a general policy, FIA gives each of its portfolio managers
full discretion to make the proxy voting decisions for their own clients. However,
tracking and voting routine proxies is discouraged as an inefficient use of firm resources.
Faced with controversial proxy votes regarding takeover defenses, compensation plans,
capital structure, or social responsibility, FIA management encourages managers to either
vote with management or sell the stock.

A. Critique two aspects of FIAs approach to proxy voting in the context of the
AIMR Standard on Fiduciary Duty. (Do not reference ERISA.)

(6 minutes)

B. Identify four specific procedures that FIA should adopt to help ensure
implementation of an adequate proxy voting policy.

(8 minutes)
CFA Level III Examination
1999 Morning Section

Important Instructions to Candidates

1. Write your candidate number in the space provided on the cover of this booklet.

2. You must return this test booklet to the proctor before you leave the exam room. If you
remove any exam materials from this room, your exam will not be graded. All test booklets
containing your written answers become the property of AIMR. They will not be returned to you in
either original or copied form. If you remove this test booklet from the exam room, you may be
subject to dismissal from the CFA Program.

3. You must write all answers in the test booklet in the appropriately numbered section. Label each
subpart of your answer (for example, A, B, C, and/or i, ii, iii, etc.). Only answers written on the
correct pages in the test booklet will be graded. Write legibly, preferably in blue or black ink. Do
not write in the margins marked for grader use only.

4. If you run out of room on the designated answer pages, you must check the box at the bottom of
the last page of your answer and continue your answer on the unnumbered extra pages found in the
back of the test booklet. Label extra pages with the appropriate question number.

5. Attempt to answer all questions. You may receive partial credit for correct work even though you
do not provide a complete response. Remember, however, that inconsistent or illogical answers
will not receive full credit.

6. Write only the required number of responses. Providing more than the required number of
responses to a question will not earn extra points. Extra responses will be ignored.

7. Show all your calculations on the correct answer pages even if the question doesnt specifically
instruct you to do so. You will be able to check your work this way. Also, if your answer is wrong,
the grader can give partial credit where warranted if you show your calculations. If the question
specifically says Show your work, you must present your calculations and, for full credit, they
must be correct.

8. No assistance in answering questions may be given to or received from others during this exam.

9. You may not use any reference materials during this exam. You must leave all reference materials
in the designated area prior to the start of the exam.

10. You may use your own silent, hand-held, battery-operated, nonalphabetic keyboard calculator, but
you must clear the programmable memory prior to the start of the exam.

Do Not Open This Book Until Instructed to Do So by the Proctor.

Do Not Remove This Book from the Exam Room.


CFA Level III FOR AIMR USE ONLY

Examination Book

1999 Afternoon Section


Candidate Number:

_____ _____ _____ _____ _____ _____

1999 Association for Investment Management and Research


All rights reserved

This book is the property of:

Association for Investment Management and Research


Post Office Box 3668
Charlottesville VA 22903-0668 (804) 980-3668
The following list contains the command words used on the Afternoon Section of
the 1999 Level III Examination. Candidates may want to refer to this list as they
formulate their answers.

calculate: To ascertain or determine by mathematical processes.

compute: To determine, especially by mathematical means.

contrast: To compare in respect to differences.

describe: To transmit a mental image, an impression, or an understanding of the nature


and characteristics of.

discuss: To discourse about through reasoning or argument; to present in detail.

evaluate: To determine or fix the value of; to determine the significance or worth of,
usually by careful appraisal and study.

explain: To give the meaning or significance of; to provide an understanding of; to


give the reason for or cause of.

formulate: To put into a systematized statement or expression; to prepare according to a


formula.

identify: To establish the identity of; to show or prove the sameness of.

justify: To prove or show to be valid, sound, or conforming to fact or reason; to


furnish grounds or evidence for.

list: To enumerate.

state: To express in words.

support: To provide with verification, corroboration, or substantiation.


The Afternoon Section of the 1999 CFA Level III Examination has 11 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question Topic Minutes


12 Portfolio Management 18
13 Portfolio Management 30
14 Portfolio Management 6
15 Portfolio Management 24
16 Asset Valuation 12
17 Asset Valuation 14
18 Portfolio Management 22
19 Portfolio Management 14
20 Asset Valuation 6
21 Ethics 16
22 Portfolio Management 18

Total 180
QUESTION 12 HAS TWO PARTS FOR A TOTAL OF 18 MINUTES.

12. Lindsay Corporation Pension Plan


Michel Dumont is Chief Financial Officer of Lindsay Corporation, which is located in the
United States, and chairs the Investment Committee for its $100 million defined-benefit
pension plan. Lindsay operates exclusively in the U.S. market and has recently
completed a five-year early retirement program. As a result of this program, many long-
time employees decided to retire early at age 60 and receive full pension benefits.
Lindsays actuary has determined the following:

60 percent of all participants in Lindsays defined-benefit pension plan are now


retired and receiving their pensions.
The required real rate of return based on actuarial assumptions for the pension fund is
5.5 percent annually.
The average age of active employees who will eventually collect retirement benefits
is 45 years.
Inflation has been stable at 2 percent annually, as measured by the U.S. Consumer
Price Index (CPI) and is forecasted to remain at this level for the foreseeable future.
The pension plan is currently fully funded, and Dumont would like to minimize the
amount of company contributions required in the future.

A. Formulate and justify investment policy objectives for the Lindsay pension plan
in the following three areas:

i. Return objective.
ii. Risk tolerance.
iii. Time horizon.

(9 minutes)

Mountaintop College Endowment Fund


Dumont is also a member of the Board of Trustees of the endowment fund at
Mountaintop College. The fund was established to provide scholarships and currently
has assets of US$ 1 billion. In addition to its U.S. campus, the college has recently
established campuses in Europe and Japan. Its spending policy was recently amended as
follows:

The new payout level will increase the spending rate from 4 percent to 6 percent of
assets each year.
35 percent of the new payout level will be awarded in local currencies to students
attending the colleges foreign branches.

The funds current asset allocation was structured to balance the objectives of near-term
funding of scholarships and longer-term, inflation-adjusted preservation of capital. The
overall volatility of the current portfolio is similar to the volatility of a domestic-only
balanced portfolio. Annual increases in college tuition are forecasted to average 3
percent globally over the long term, and inflation is forecast to remain at 2 percent
annually as measured by U.S. CPI.

B. Discuss each of the following for the endowment fund. Specifically address the
impact of the change in the funds spending policy, where applicable.

i. Return objective.
ii. Risk tolerance.
iii. Time horizon.

(9 minutes)
QUESTION 13 HAS TWO PARTS FOR A TOTAL OF 30 MINUTES.

13. The current asset allocation of the Mountaintop College endowment fund is shown in
Exhibit 13-1 below.

A. State whether the current allocation to each asset class as shown in Exhibit 13-1
should be lower, the same, or higher, given the revised spending plan and new
foreign campuses discussed in the previous question. Justify your response with
reference to each of the asset classes.

Note: No calculations are required. State your assumptions clearly. Hedging is not
permitted in the fund.

Answer Question 13A in the Template provided on pages 15 and 16.

(15 minutes)

Exhibit 13-1
Long-Term Expected Returns and Volatility
(in percent)
Expected Return Expected Standard
Asset Class (US$) Deviation Current Allocation
Cash 4 3 2
U.S. bonds 6 8 30
International bonds 7 11 0
U.S. equities 10 16 60
EAFE equities 12 22 8

Dumont also believes that the current asset allocation for Mountaintop Colleges
endowment fund is an appropriate long-term allocation for Lindsays pension plan.

B. State whether the current allocation to each asset class as shown in Exhibit 13-1
should be lower, the same, or higher for Lindsays pension plan. Justify your
response with reference to each of the asset classes.

Note: No calculations are required. State your assumptions clearly. Hedging is not
permitted in the fund.

Answer Question 13B in the Template provided on pages 17 and 18.

(15 minutes)
Template for Question 13A
Assessment of Allocation for Mountaintop College Endowment Fund
Asset Class
and Current Circle Change (Lower/Same/Higher) and Justify your response.
Allocation STATE YOUR ASSUMPTIONS CLEARLY.

Lower Same Higher

Cash

(2%)

Lower Same Higher

U.S. Bonds

(30%)

Lower Same Higher

International
Bonds

(0%)

(Template for Question 13A continued on next page)


Asset Class
and Current Circle Change (Lower/Same/Higher) and Justify your response.
Allocation STATE YOUR ASSUMPTIONS CLEARLY.

Lower Same Higher

U.S. Equities

(60%)

Lower Same Higher

EAFE
Equities

(8%)
Template for Question 13B
Assessment of Allocation for Lindsay Corporation Pension Plan
Asset Class
and Current Circle Change (Lower/Same/Higher) and Justify your response.
Allocation STATE YOUR ASSUMPTIONS CLEARLY.

Lower Same Higher

Cash

(2%)

Lower Same Higher

U.S. Bonds

(30%)

Lower Same Higher

International
Bonds

(0%)

(Template for Question 13B continued on next page)


Asset Class
and Current Circle Change (Lower/Same/Higher) and Justify your response.
Allocation STATE YOUR ASSUMPTIONS CLEARLY.

Lower Same Higher

U.S. Equities

(60%)

Lower Same Higher

EAFE
Equities

(8%)
QUESTION 14 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

14. Explain how each of the following three costs implicit in the execution of a trade is
measured. In your explanation of each cost, make specific reference to the time required
for completion of the trade.

i. Market impact cost.


ii. Timing cost.
iii. Opportunity cost.

(6 minutes)
QUESTION 15 HAS TWO PARTS FOR A TOTAL OF 24 MINUTES.

15. A. Describe the following three methods of calculating the value at risk (VAR) of an
investment. Identify one unique strength and one unique weakness of each
method.

i. Variance/covariance.
ii. Historical simulation.
iii. Monte Carlo simulation.

(18 minutes)

Two consultants use the Monte Carlo simulation method to calculate monthly value at
risk for the same portfolio.

B. Discuss two reasons why the consultants may obtain dramatically different VAR
results for the same portfolio.

(6 minutes)
QUESTION 16 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.

16. Jerod Jacob is the senior investment officer for a large, fully funded U.S. pension fund
that uses external management and currently invests only in domestic securities. The
fund has aggressive return objectives and a high tolerance for risk.

Jacob believes that global fixed-income markets provide additional opportunity for
increasing the funds returns through active bond management and wants to expand the
funds exposure to include international bonds. As a result, Jacob has decided to fully
hedge the currency exposure in his global fixed-income portfolio.

A. Discuss one advantage and one disadvantage of using a fully hedged portfolio
strategy.

(6 minutes)

B. Evaluate Jacobs decision to use a fully hedged portfolio strategy, given his
funds return objectives and risk tolerance.

(6 minutes)
QUESTION 17 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.

17. A consultant suggests that the weighted-average portfolio duration calculation for a
global bond portfolio is the same as for a domestic bond portfolio.

A. State whether the use of portfolio duration in international bond portfolio


management is more limiting than in domestic bond portfolio management.
Support your conclusion with two reasons.

(8 minutes)

The consultant recognizes that currency, duration, and investing outside the benchmark
are possible sources of excess return in global bond management. He is also curious
about additional methods of adding value through global bond management.

B. List and discuss two additional potential sources of excess return.

(6 minutes)
QUESTION 18 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES.

18. Alex Andrew, who manages a $95 million large-capitalization U.S. equity portfolio,
currently forecasts that equity markets will decline soon. Andrew prefers to avoid the
transactions costs of making sales but wants to hedge $15 million of the portfolios
current value using S&P 500 futures.

Because Andrew realizes that his portfolio will not track the S&P 500 Index exactly, he
performs a regression analysis on his actual portfolio returns versus the S&P futures
returns over the past year. This regression analysis indicates a risk-minimizing beta of
0.88 with an R2 of 0.92.

Exhibit 18-1
Futures Contract Data
S&P 500 futures price 1,000
S&P 500 Index 999
S&P 500 Index multiplier 250

A. Calculate the number of futures contracts required to hedge $15 million of


Andrews portfolio, using the data in Exhibit 18-1. State whether the hedge is
long or short. Show all calculations.

(6 minutes)

B. Identify two alternative methods (other than selling securities from the portfolio
or using futures) that replicate the futures strategy in Part A. Contrast each of
these methods with the futures strategy.

(10 minutes)

Three months later, Andrews revised forecast indicates that a rebound in the market is
imminent. Also, $5 million of cash has just been added to the portfolio. Andrew is
considering investing the cash in U.S. Treasury bills until he decides which additional
large-capitalization stocks to buy in anticipation of the market rebound. Andrew is
prohibited from leveraging the portfolio.

Exhibit 18-2
Capital Market Data
Expected Return
S&P 500 Index 12.00%
U.S. Treasury bill yield 6.00
Synthetic S&P 500 Index fund (with futures) 11.80
C. i. Describe a cash management strategy for this equity portfolio that could be used
as an alternative to holding Treasury bills.

ii. Compute the cost to the portfolio (in percentage terms) of holding the excess $5
million cash in U.S. Treasury bills, using the information in Exhibit 18-2.

iii. Compute the return enhancement (in percentage terms) of using a futures-based
cash management strategy, using the data in Exhibit 18-2.

(6 minutes)
QUESTION 19 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.

19. ECB Inc. is a corporate pension fund sponsor. Sloan & Company is ECBs only U.S.
equity manager and operates under a mandate that allows Sloan to invest in any U.S.
equity. ECB has historically measured the investment performance of Sloan against a
median manager benchmark. The benchmark performance is derived from a broad
universe of U.S. equity managers.

A. Evaluate ECBs use of the median manager approach to measure


equity performance. Justify your response by referencing each of four
characteristics of an effective benchmark.

(10 minutes)

As an alternative to the median manager approach, ECBs treasurer has suggested


using the S&P 500 Index as a benchmark for evaluating Sloans investment performance.

B. Describe two problems with using the S&P 500 Index as an appropriate
benchmark for evaluating Sloans investment performance.

(4 minutes)
QUESTION 20 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

20. The Board of Trustees of the Northern Company pension plan is considering the addition
of direct real estate investments to its diversified US$ 500 million pension portfolio. This
would be accomplished by acquiring commercial office buildings, shopping centers,
industrial warehouses, and residential properties. A consultant has told the Board:

Our meanvariance computer model uses statistical data to optimize all asset classes.
Based on that model, I recommend an optimal portfolio for Northern containing a 40
percent allocation of the portfolio to direct real estate investments, given the risk and
return objectives set by the board for the fund.

Evaluate the consultants statement by addressing the return and risk characteristics of
the data and the resulting recommendation of the consultant.

(6 minutes)
QUESTION 21 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES.

21. Anne Jennings is the portfolio manager for the Quality Growth Mutual Fund (the Fund).
In the Funds prospectus, Jennings describes the Funds investment strategy as aggressive
growth. The Funds objective is to achieve a high level of asset growth by remaining
fully invested in small and micro-cap stocks.

Shortly after becoming the Funds manager, Jennings invests 55 percent of the Funds
assets in U.S. Treasury bills. Based on interest rate forecasts from her firms research
department, she believes that a substantial long-term commitment in these securities will
benefit the Fund.

Shortly after the Treasury bill purchase, Jennings invests 8 percent of the Funds assets in
Biocure stock. Biocure is a small, thinly traded pharmaceutical research company.
Jennings already personally owns US $100,000 of stock in Biocure. Despite the recent
decline of the stock price, Jennings believes the investment will ultimately be a good
long-term investment. She justifies the investment in Biocure by pointing to long-term
earnings projections from her firms research department that continue to be extremely
positive.

A. Discuss Jennings purchase of U.S. Treasury bills for the Fund. Given only the
facts presented, address the following four concepts contained in the AIMR
Standards of Professional Conduct:

i. Suitability.
ii. Misrepresentation.
iii. Client interests versus personal interests.
iv. Disclosure of conflicts.

Answer Question 21A in the Template provided on page 57.

(8 minutes)

B. Discuss Jennings purchase of Biocure stock for the Fund. Given only the facts
presented, address the following four concepts contained in the AIMR Standards
of Professional Conduct:

i. Suitability.
ii. Misrepresentation.
iii. Client interests versus personal interests.
iv. Disclosure of conflicts.

Answer Question 21B in the Template provided on page 59.

(8 minutes)
Template for Question 21A
U.S. Treasury Bill Investment
Suitability:

Misrepresentation:

Client Interest/ Personal Interest:

Disclosure of Conflicts:
Template for Question 21B
Biocure Investment
Suitability:

Misrepresentation:

Client Interest/ Personal Interest:

Disclosure of Conflicts:
QUESTION 22 HAS ONE PART FOR A TOTAL OF 18 MINUTES.

22. In 1994, Alex Halsey, an investment analyst, and Rachel Martin, a portfolio manager,
both quit their jobs and formed HM Investment Advisors (HM). Initially, Martin brought
a dozen of her clients from her previous firm, and several more clients were attracted by
Halseys reputation as an analyst.

Since 1994, HM has had difficulty attracting new clients because their performance
record was slightly worse than average. To attract new clients, the firm prepared an
investment performance presentation that includes the performance history for each of
the firms three styles of management: equity, balanced, and fixed income.

For the equity return, the firm combines


the performance record of all HM equity accounts,
Martins performance record while she served on the stock selection committee of her
previous firm, and
the performance record for the equity portion of the firms balanced accounts,
excluding cash.

For the balanced return, the firm uses


the performance history of all its balanced accounts currently under management and
supplements these numbers with the simulated performance of a model portfolio.

For the fixed-income return, the firm only uses


the performance history for three selected accounts and
annual numbers from 1996 to the present.

Describe how the requirements of the AIMR Performance Presentation Standards


(AIMR-PPS standards) apply to each of the following six actions of HM when presenting
their performance, given only the facts presented:

i. Use of Martins investment record at her former firm.


ii. Use of the equity segments of HMs balanced accounts.
iii. Use of HMs balanced accounts currently under management.
iv. Use of model performance.
v. Use of three selected HM fixed-income accounts.
vi. Providing annual numbers from 1996 to the present.

Answer Question 22 in the Template provided on pages 63, 64, and 65.

(18 minutes)
Template for Question 22
Application of the AIMR-PPS standards
i. Use of Martins investment record at her former firm:

ii. Use of the equity segments of HMs balanced accounts:

(Template for Question 22 continued on next page)


iii. Use of HMs balanced accounts currently under management:

iv. Use of model performance:

(Template for Question 22 continued on next page)


v. Use of three selected HM fixed-income accounts:

vi. Providing annual numbers from 1996 to the present:


CFA Level III Examination
1999 Afternoon Section

Important Instructions to Candidates

1. Write your candidate number in the space provided on the cover of this booklet.

2. You must return this test booklet to the proctor before you leave the exam room. If you
remove any exam materials from this room, your exam will not be graded. All test booklets
containing your written answers become the property of AIMR. They will not be returned to you in
either original or copied form. If you remove this test booklet from the exam room, you may be
subject to dismissal from the CFA Program.

3. You must write all answers in the test booklet in the appropriately numbered section. Label each
subpart of your answer (for example, A, B, C, and/or i, ii, iii, etc.). Only answers written on the
correct pages in the test booklet will be graded. Write legibly, preferably in blue or black ink. Do
not write in the margins marked for grader use only.

4. If you run out of room on the designated answer pages, you must check the box at the bottom of
the last page of your answer and continue your answer on the unnumbered extra pages found in the
back of the test booklet. Label extra pages with the appropriate question number.

5. Attempt to answer all questions. You may receive partial credit for correct work even though you
do not provide a complete response. Remember, however, that inconsistent or illogical answers
will not receive full credit.

6. Write only the required number of responses. Providing more than the required number of
responses to a question will not earn extra points. Extra responses will be ignored.

7. Show all your calculations on the correct answer pages even if the question doesnt specifically
instruct you to do so. You will be able to check your work this way. Also, if your answer is wrong,
the grader can give partial credit where warranted if you show your calculations. If the question
specifically says Show your work, you must present your calculations and, for full credit, they
must be correct.

8. No assistance in answering questions may be given to or received from others during this exam.

9. You may not use any reference materials during this exam. You must leave all reference materials
in the designated area prior to the start of the exam.

10. You may use your own silent, hand-held, battery-operated, nonalphabetic keyboard calculator, but
you must clear the programmable memory prior to the start of the exam.

Do Not Open This Book Until Instructed to Do So by the Proctor.

Do Not Remove This Book from the Exam Room.